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NASD Task Force Calls for More Disclosure About Soft Dollars

The NASD's Mutual Fund Task Force recommends that the SEC mandate enhanced disclosure to mutual fund boards of directors on soft dollar practices and transaction costs. The task force believes that the SEC should take steps to ensure that every fund board understands the types of information that should be reviewed in exercising effective oversight of an adviser's soft dollar practices. Generally, the task force believes that these issues can best be addressed through a combination of greater transparency for both fund boards and investors, and tightened standards regarding the use of soft dollars for research.

The task force urged the SEC to require the adviser to provide fund directors with an array of information, including portfolio turnover rate, a list of brokers used and the total dollar amount of commissions paid to each broker, the price of research offered by each broker, and the amount of third-party research benefits obtained with fund brokerage commissions.

According to the task force, the disclosure mandate will support a more rigorous discipline on the purchase of research and brokerage services with soft dollars, particularly in the context of the board's consideration of the fund adviser's management fee. At the same time, the task force reaffirmed that independent research is valuable and that it is appropriate to use fund commissions to acquire third-party research under the safe harbor in 1934 Act section 28(e).

The task force was created to help inform SEC rule proposals. Its work is proceeding in two phases. In the first phase, on which the report is based, the task force considered mutual fund portfolio transaction costs. In the second phase, the task force will focus on distribution arrangements, including rule 12b-1 fees and revenue sharing.

While there is no statutory definition for soft dollars, the SEC has defined the term to mean products and services, other than the execution of securities transactions, that an investment manager receives from a broker in exchange for the adviser's direction of client brokerage transactions to the broker (see, Rel. No. 34-35375). Section 28(e) of the 1934 Act provides a safe harbor for money managers, which allows them to pay a higher commission rate based on their determination that the rate is reasonable in relation to the value of the brokerage or research services received from a broker.

Section 28(e), which contains a broad definition of brokerage and research services, reflects a Congressional determination that the use of client commission dollars to obtain research and brokerage services is both a service to investors and a benefit to the securities markets. For its part, the SEC has interpreted research services to include products or services providing lawful and appropriate assistance to money managers in carrying out their duties.

As a threshold matter, the task force believes that the section 28(e) safe harbor should be preserved since investors are best served when research of all types is widely available to all investment managers. The task force noted that soft dollar practices may be especially beneficial to the clients of smaller investment advisers since they cannot afford a large internal research staff or extensive hard dollar payments for research. They can supplement their internal research efforts through the use of soft dollar arrangements.

The task force also recognized that the advantages of the safe harbor must be balanced against the need to address the potential conflicts of interest and disclosure issues that its existence raises. The task force recommended that the SEC narrow its interpretation of the scope of research services for purposes of the safe harbor to better tailor it to the types of services that principally benefit clients rather than the adviser. The SEC was also urged to require enhanced disclosure to fund shareholders about portfolio transaction costs, and to apply disclosure requirements to all types of commissions.

Further, the task force asked the SEC to mandate that advisers provide information concerning portfolio transaction costs to fund boards and to ensure that fund boards obtain appropriate information regarding a fund adviser's brokerage allocation practices, including soft dollar products and services received. The task force also urged the SEC to consider soft dollar issues raised by other managed advisory accounts.

A substantial number of task force members believe that the SEC should require an adviser to provide a fund board with a good faith estimate of the amount of proprietary research obtained with fund brokerage commissions. This recommendation is based on the belief that a board might have an incomplete understanding of the amount of research obtained by the adviser through fund brokerage unless third-party research figures are augmented by proprietary research amounts.

There was no consensus for providing such information to investors. The overwhelming majority of the task force concluded that it would be misleading to investors to provide such information, given the inherently subjective nature of estimating the value of the proprietary soft dollar benefit.

The task force rejected the idea of requiring a fund to disclose to investors whether its manager relies on the section 28(e) safe harbor and, if so, to provide a reasonable, good faith estimate of the percentage of commissions used to obtain soft dollar benefits. Absent a uniform methodology to measure that percentage, task force members worried that such disclosure would lack comparability across fund groups. In addition, even if accompanied by explanatory narrative disclosure, the probability that numerical breakdowns would mislead or confuse investors would outweigh the potential benefits of disclosure.

Rather than requiring funds to provide quantitative estimates of soft dollar use, the task force recommended that the SEC require a fund to tell shareholders whether it obtains third-party research through soft dollars and whether it obtains proprietary research through soft dollars. This disclosure should be included in the fund prospectus and should not be relegated to the statement of additional information, according to the task force.

Although the section 28(e) safe harbor is available to all discretionary money managers, only mutual fund and pension fund managers must meet the safe harbor due to the self-dealing limitations under section 17 of the Investment Company Act and ERISA. Other managers, such as hedge fund managers, may engage in soft dollar practices that do not fall within the scope of section 28(e).

Since it does not make sense to have different soft dollar rules apply depending on the type of managed advisory account executing the transaction, the task force urged the SEC to consider making compliance with section 28(e) mandatory for all discretionary investment advisers, whether or not registered with the SEC. The task force said the Commission should recommend to the Department of Labor and the federal banking regulators that they require all other discretionary investment managers that are not subject to SEC jurisdiction to comply with the standards of the safe harbor.

With regard to trading costs, the task force urged the SEC to require the adviser to disclose to the fund directors its policies and procedures for monitoring transaction costs and brokerage allocation along with information about the reasonableness of all transaction costs, including commissions, commission equivalents and mark-ups. The board is expected to use this information to determine whether the adviser is sufficiently ensuring that the fund does not pay excessive transaction costs and is adequately monitoring the execution quality of the fund's transactions.

The task force also recommended that the SEC require enhanced disclosure to fund shareholders about trading costs. The SEC should require a brief narrative description in the prospectus of the various types of trading costs incurred by the fund, in the task force's view. In addition, the prospectus should contain the percentage of the total dollar value of all transactions executed on a commission basis, the average commission paid and the total commissions paid as a percentage of total net asset value.